September 16, 2011 8:34 pm
Eurozone: A nightmare scenario
By Chris Giles
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As Europe’s leaders pledge support for the single currency, the talk among some is of default. An outline of the possible outcomes
As Europe’s leaders pledge support for the single currency, the talk among some is of default. An outline of the possible outcomes
“If the euro fails, then Europe fails.”
Angela Merkel’s staunch defence of the single currency, made in the Bundestag this month, is widely shared by other European leaders. The German chancellor’s sentiment demonstrates the political will not to let Europe’s sovereign debt crisis undermine the single currency.
Plan A, as far as European authorities are concerned, is to implement the agreement struck on July 21. Under the deal, Greece was offered a second programme of loans, worth €109bn, including the guarantee that Athens would not need to return to financial markets for years, borrowing instead from other European countries and the International Monetary Fund at low interest rates. The private sector would take a writedown of its debt to help ease the burden facing Greece. And the European financial stability facility – the temporary bail-out fund – would become more flexible in order to limit contagion from one eurozone country’s bonds to others.
By 2013, the replacement permanent European stability mechanism should be in place to provide greater economic governance in the eurozone, and as a fund to ensure that countries with difficulties borrowing in the markets had rapid access to loans alongside adjustment programmes until they were again able to roll over their debt in the markets.
That is the plan. But in the meantime, something might give – such is the unpredictability of events in a crisis. In those circumstances, Greece could default. A momentous decision not to service its debts – owed to other European countries, banks and the private sector – would start an alternative, and potentially dangerous, sequence of events.
Because Athens still does not raise sufficient tax revenues to fund its public services, it would fail to pay all of its domestic bills. Public sector workers might not be paid, some social security benefits might fall short. The shock of default and the lack of money would send the economy reeling.
At the same time as the Greek state ran out of money, the country’s banks would face collapse because their holdings of domestic sovereign bonds would be heavily written down. The European Central Bank could not accept defaulted bonds as collateral to lend to banks, since they would be worth little.
The closure, even temporarily, of payment systems and cash machines would amplify the problems. To restart normal economic life, Greece would need to recapitalise its banks and balance its books on a day-to-day basis.
If creditors were willing to lend fresh money to Athens, the direct consequences could stop there. But finding new lenders after default is not easy.
The alternative would be to restore Greece’s ability to create money to pay its bills – and that would require exit from the euro, to re-establish the central bank’s ability to create money.
The effects of any default would not be limited to Greece, however, since the investors would then question who was next. In a bid to avoid big losses, euros would flow from countries deemed at risk to those deemed safe. The sums are potentially huge, and the flows would reduce the value of sovereign debt of “at risk” nations.
Plunging bond prices would further undermine many European banks and confidence in eurozone economies.
A further slowdown would amplify this contagion. While the ECB has the firepower to fund eurozone banks so long as they are solvent, any economic dislocation caused by contagion could become so severe that other countries would have to to borrow more and on ever more unreasonable terms. More countries could decide to default.
If one country were to leave the euro, the fear would rise that others would follow, creating exchange rate risk across the zone – smart euros would fly out of, say, Tuscany and into Bavaria in case Italy also left the euro. Even so, the ECB could act as a circuit breaker, offering to buy unlimited sovereign bonds of countries under pressure – but that would require agreement across the zone that such purchases were acceptable.
If such unity were lacking – as it has been to date – other countries could find themselves with little option but to follow Greece out of the single currency, which could then break apart.
None of these events is inevitable. But such are the vicious feedback loops in the system that everyone should be aware of the considerable risks. Should Athens default, the risks are real that both the euro and Europe would fail.
Latin lessons
Part 1: Death of a single currency
Open strife between France and Germany is putting strain on a newly single currency in western Europe, and Italy is trying to get everyone else to subsidise its chronic fiscal profligacy.
Sound familiar? On this occasion the conflict is the Franco-Prussian war of 1870-71, and Italy’s monetary sleight of hand involves printing paper notes when it should have been minting silver coins. The Latin Monetary Union, formed in 1865, brought together France, Belgium, Switzerland and Italy in an attempt to formalise a decades-old tradition in which the four countries used France’s bimetallic currency system. Coins were minted from silver or gold, and the exchange rate between the two metals was fixed by law.
But the union suffered the perennial problem of bimetallic systems: anyone could exploit the difference between the fixed ratio of gold to silver prices and their actual market values by melting down coins of which ever metal was undervalued, and selling the result. Foolishly, the union also failed to outlaw the printing of paper money based on the metal currency. France resorted temporarily to banknotes, to fund the war with Prussia and Italy did so more or less continuously – in effect, forcing other members of the union to bear some of the cost of its fiscal extravagance by issuing notes backed by their currency.
Although the union limped on until 1925, it was in reality killed by the first world war. To pay for the conflict, members printed paper money that was legal tender only in the nation that created it. Many of the silver coins ended up being melted down or exported for their metal value.
.
– Alan Beattie
Part 2: Argentina defaults
Argentina’s default on $100bn in December 2001 was catastrophic for the country – but not in itself a watershed for the population.
State-sector wages were still paid, albeit in part with so-called “quasi currencies” that had been circulating for several months as pesos ran short. The lights stayed on, and in the supermarkets there were still things to buy. People struggled to pay for goods, but that was because of the corralito – the government’s surprise clampdown on cash withdrawals three weeks earlier – rather than the default. The measure sparked long queues at fast-emptying cash machines, fatal riots and unprecedented political turmoil – the chaos worsened in January 2002, when a brutal devaluation ended a decade of the peso’s artificial parity with the dollar.
In response, as 40 per cent of the population sank into poverty and formerly middle-class people foraged in waste bins for food, the government froze utilities tariffs and subsidised public transport. It also increased revenues by slapping taxes on Argentine exports – still a vital revenue stream from the crucial agriculture sector today. With the country cut off from international credit, a situation unchanged a decade on, president Hugo Chávez of Venezuela stepped in as a creditor but painfully high rates made that only a stopgap solution. High growth helped keep Argentina afloat but Buenos Aires finally began seeking domestic sources: pension funds were nationalised in 2008 and, from last year, central bank reserves have been tapped to pay debt. Argentina has paved the way for a return to international bond markets, using two swaps in 2005 and 2010 to restructure more than 92 per cent of defaulted debt, though it still owes $7bn to 19 governments in the Paris Club.
– Jude Webber
Angela Merkel’s staunch defence of the single currency, made in the Bundestag this month, is widely shared by other European leaders. The German chancellor’s sentiment demonstrates the political will not to let Europe’s sovereign debt crisis undermine the single currency.
.
So long as this level of political capital is invested in the euro, monetary union is highly likely to survive. However, the talk among investors and some European politicians this week has been of Greek default. The graphic below outlines the likely consequences of a default by Greece.
So long as this level of political capital is invested in the euro, monetary union is highly likely to survive. However, the talk among investors and some European politicians this week has been of Greek default. The graphic below outlines the likely consequences of a default by Greece.
.
It is a description, not a prediction – a description that includes the possibility of the break-up of the eurozone, though even in the event of Greek default that outcome is far from inevitable.
It is a description, not a prediction – a description that includes the possibility of the break-up of the eurozone, though even in the event of Greek default that outcome is far from inevitable.
Plan A, as far as European authorities are concerned, is to implement the agreement struck on July 21. Under the deal, Greece was offered a second programme of loans, worth €109bn, including the guarantee that Athens would not need to return to financial markets for years, borrowing instead from other European countries and the International Monetary Fund at low interest rates. The private sector would take a writedown of its debt to help ease the burden facing Greece. And the European financial stability facility – the temporary bail-out fund – would become more flexible in order to limit contagion from one eurozone country’s bonds to others.
By 2013, the replacement permanent European stability mechanism should be in place to provide greater economic governance in the eurozone, and as a fund to ensure that countries with difficulties borrowing in the markets had rapid access to loans alongside adjustment programmes until they were again able to roll over their debt in the markets.
That is the plan. But in the meantime, something might give – such is the unpredictability of events in a crisis. In those circumstances, Greece could default. A momentous decision not to service its debts – owed to other European countries, banks and the private sector – would start an alternative, and potentially dangerous, sequence of events.
Because Athens still does not raise sufficient tax revenues to fund its public services, it would fail to pay all of its domestic bills. Public sector workers might not be paid, some social security benefits might fall short. The shock of default and the lack of money would send the economy reeling.
At the same time as the Greek state ran out of money, the country’s banks would face collapse because their holdings of domestic sovereign bonds would be heavily written down. The European Central Bank could not accept defaulted bonds as collateral to lend to banks, since they would be worth little.
The closure, even temporarily, of payment systems and cash machines would amplify the problems. To restart normal economic life, Greece would need to recapitalise its banks and balance its books on a day-to-day basis.
If creditors were willing to lend fresh money to Athens, the direct consequences could stop there. But finding new lenders after default is not easy.
The alternative would be to restore Greece’s ability to create money to pay its bills – and that would require exit from the euro, to re-establish the central bank’s ability to create money.
The effects of any default would not be limited to Greece, however, since the investors would then question who was next. In a bid to avoid big losses, euros would flow from countries deemed at risk to those deemed safe. The sums are potentially huge, and the flows would reduce the value of sovereign debt of “at risk” nations.
Plunging bond prices would further undermine many European banks and confidence in eurozone economies.
A further slowdown would amplify this contagion. While the ECB has the firepower to fund eurozone banks so long as they are solvent, any economic dislocation caused by contagion could become so severe that other countries would have to to borrow more and on ever more unreasonable terms. More countries could decide to default.
If one country were to leave the euro, the fear would rise that others would follow, creating exchange rate risk across the zone – smart euros would fly out of, say, Tuscany and into Bavaria in case Italy also left the euro. Even so, the ECB could act as a circuit breaker, offering to buy unlimited sovereign bonds of countries under pressure – but that would require agreement across the zone that such purchases were acceptable.
If such unity were lacking – as it has been to date – other countries could find themselves with little option but to follow Greece out of the single currency, which could then break apart.
None of these events is inevitable. But such are the vicious feedback loops in the system that everyone should be aware of the considerable risks. Should Athens default, the risks are real that both the euro and Europe would fail.
Latin lessons
Part 1: Death of a single currency
Open strife between France and Germany is putting strain on a newly single currency in western Europe, and Italy is trying to get everyone else to subsidise its chronic fiscal profligacy.
Sound familiar? On this occasion the conflict is the Franco-Prussian war of 1870-71, and Italy’s monetary sleight of hand involves printing paper notes when it should have been minting silver coins. The Latin Monetary Union, formed in 1865, brought together France, Belgium, Switzerland and Italy in an attempt to formalise a decades-old tradition in which the four countries used France’s bimetallic currency system. Coins were minted from silver or gold, and the exchange rate between the two metals was fixed by law.
But the union suffered the perennial problem of bimetallic systems: anyone could exploit the difference between the fixed ratio of gold to silver prices and their actual market values by melting down coins of which ever metal was undervalued, and selling the result. Foolishly, the union also failed to outlaw the printing of paper money based on the metal currency. France resorted temporarily to banknotes, to fund the war with Prussia and Italy did so more or less continuously – in effect, forcing other members of the union to bear some of the cost of its fiscal extravagance by issuing notes backed by their currency.
Although the union limped on until 1925, it was in reality killed by the first world war. To pay for the conflict, members printed paper money that was legal tender only in the nation that created it. Many of the silver coins ended up being melted down or exported for their metal value.
.
– Alan Beattie
Part 2: Argentina defaults
Argentina’s default on $100bn in December 2001 was catastrophic for the country – but not in itself a watershed for the population.
State-sector wages were still paid, albeit in part with so-called “quasi currencies” that had been circulating for several months as pesos ran short. The lights stayed on, and in the supermarkets there were still things to buy. People struggled to pay for goods, but that was because of the corralito – the government’s surprise clampdown on cash withdrawals three weeks earlier – rather than the default. The measure sparked long queues at fast-emptying cash machines, fatal riots and unprecedented political turmoil – the chaos worsened in January 2002, when a brutal devaluation ended a decade of the peso’s artificial parity with the dollar.
In response, as 40 per cent of the population sank into poverty and formerly middle-class people foraged in waste bins for food, the government froze utilities tariffs and subsidised public transport. It also increased revenues by slapping taxes on Argentine exports – still a vital revenue stream from the crucial agriculture sector today. With the country cut off from international credit, a situation unchanged a decade on, president Hugo Chávez of Venezuela stepped in as a creditor but painfully high rates made that only a stopgap solution. High growth helped keep Argentina afloat but Buenos Aires finally began seeking domestic sources: pension funds were nationalised in 2008 and, from last year, central bank reserves have been tapped to pay debt. Argentina has paved the way for a return to international bond markets, using two swaps in 2005 and 2010 to restructure more than 92 per cent of defaulted debt, though it still owes $7bn to 19 governments in the Paris Club.
– Jude Webber
Copyright The Financial Times Limited 2011.
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